Monday, 10 June 2013

Close your eyes and hope for the best

Some advice for how
to ride out the upcoming twists and turns in the markets.

Your Neighbourhood Economist tries to remain impartial when
writing, but like many people, has a certain amount invested in the topics that
are mentioned on this blog. For most of
us, it is our employment which can make us vulnerable to the ups and downs of
the global economy. But for some who
have a bit stashed away here and there, putting any extra cash to good use is a
tricky predicament at this time. It
seems to be like riding a roller coaster in the dark – hence the title of this
article – is the best investment advice that Your Neighbourhood Economist could
come up with and here is why.

Investment options can be categorised into two types (or a
mixture of both) – safe or risky. With
many countries in the developed world still suffering a hangover from the
aftermath of the global financial crisis, it would seem as if the clever move
would be to go down the safe route. But
the safe option - bonds - has been jumped on by so many investors that returns
from bonds have hit record lows in many places, such as debt from countries
like Germany or the UK, which are seen as refuges from the turmoil elsewhere.
Even the banks with their own problems are paying out higher interest rates
than the more prudent options in the bond market.

With such a meagre pay-off from playing it safe, money has
been migrating to riskier options with higher returns with shares being the
obvious example of a riskier investment. As such, some of the indices for the big stock
markets such as the Dow Jones in the US have hit record highs. This may seem a bit strange considering the
doom and gloom surrounding the outlook for the global economy but it is a
phenomenon which has been engineered by central banks across the globe. Their policy of printing loads of cash has
been targeting increased lending and a boost to the prices of assets that you
and I might hold such as real estate or stocks. This increase in asset prices is meant to help
us open up our wallets and be more willing to spend (a phenomenon referred to
as the “wealth effect”) despite the lingering possibility of job losses and
sluggish increases in wages.

There is a fatal flaw in this scenario that makes investing
in this seemingly booming market for stocks even more of a risk. Central banks will have to shut off the flow
of cash sometime. The main concern for
central banks is inflation and keeping it at a sufficiently low level. But more money, when people actually spend it,
leads to higher prices which will be the result of the central bank policies
once economic growth returns in earnest. So the flow of extra cash from central banks
which has pumped up share prices will end at some point in time over the next
few years.

The timing all depends on the state of the economy in
different countries with the Federal Reserve in the US already signalling that
it will soon taper off its buying of bonds depending on a continued fall in
unemployment. The European Central Bank
has its monetary policy on hold for the moment as the economic situation in
Europe gradually improves but may act if another crisis kicks off, while the
central bank in Japan has ramped up its monetary policy with the stagnating
economy seemingly impervious to previous bouts of monetary stimuli.

This puts potential investors on a scary part of the
metaphorical roller coaster ride of investing in the stock market. There has been a big drop in the market with
the financial crisis and the upward turn as share prices bottomed out, but
where to next? To complicate matters, it
is the cash coming out of the central banks more than the actual state of the
economy that seems to dictate share prices. This has led to a paradoxical situation where
the stock market can fall due to positive news on the economy as robust
economic growth would prompt central banks to shut off the flow of cash.

The result is a lot of twists and turns ahead
as the market players try to assess the future of monetary policy, the
direction of the global economy, and how other investors will react amongst all
of this. What is bound to ensue is a lot
of screaming over both the good and bad.
But with few other easy investment options available, there may be
little else to do but invest in stocks, close your eyes and hope for the best.